APPENDIX

Notes for FOMC Meeting September 18, 1979

Scott E. Pardee

For some two weeks after the August 14 FOMC meeting, the exchange markets were relatively quiet. The tone for the dollar was better, largely in response to the tightening actions by the Federal Reserve. News of a sharply reduced U. S. trade deficit in July also helped. Trading in dollar/mark remained balanced, with little intervention either by the Federal Reserve or the Bundesbank. But market sentiment was still so bearish toward the dollar--on relative inflation rates, energy policy, and the credibility of leadership in the United States--that most of those who sold dollars in June and July held back from covering short positions or otherwise shifting hack into dollars. A few professional traders had gone long dollars in late July-early August on the expectation of a reflux of funds, which would bid up dollar rates. However, when that did not occur they wondered why and began to give credence to the many reports circulating in the market that the Bundesbank and other central banks were selling dollars to keep the dollar rates from rising. As for the Bundesbank, this was not the case; except for routine business, as far as we know it was on the sidelines. But the Swiss National Bank was a heavy seller of dollars in keeping the franc from falling against the mark. Also the Bank of Japan sold dollars to stem the decline of the yen. Many market participants took those sales as proof enough of central banks’ intentions, including those of the Bundesbank. This view even made its way into the many market commentaries sent out to corporate treasures and other portfolio managers, giving then all the more reason to refrain from buying dollars. If the Bundesbank would not let the dollar go up, so the argument ran, the dollar could only go down.

Then, coming into late August, the Bundesbank, in its efforts to keep liquidity tight in the face of rising domestic loan demand, decided to cut hack on what it considered excessive borrowing of German banks under the Lombard facility. It sought to shift the hanks’ demands for liquidity by offering a repurchase-agreement type of facility. As happens in the best of central banks, the Bundesbank miscalculated and found that it created substantially more liquidity under the repurchase agreement than it took away under the Lombard facility, and so it shifted to a third instrument, foreign exchange swaps, to mop up the excess. But this embarrassing incident for the Bundesbank was widely interpreted as a stratagem. The view in the market was that the Bundesbank was trying to keep up with or one step ahead of the Federal Reserve’s efforts to firm up conditions in the United States. In fact, short-term interest rates in Germany did rise almost as much as U. S. rates did during the period.

These events occurred against the background of considerable press commentary about a possible interest rate war and Representative Reuss’s letter complaining about Germany’s interest rate policy. These charges have been countered by U. S. officials, but the feeling remained in the market that cooperation among central banks had somehow broken down. This not only applied to bilateral relations between the United States and Germany but also to relations within the European Community.

2

The Germans have a strong hand at the moment. Very few market participants question the determination of the Bundesbank to fight inflation in Germany, either through having the mark appreciate in the exchange market or through tightening domestic monetary policy. Many in the market are thus prepared to interpret about everything the Germans do as favoring the mark, and on that basis the mark is considered an attractive hedge. More generally, some investors consider gold to be an even surer bet, and the recent surge of demand in that market has pushed the price to $380 an ounce, nearly eleven times what we were defending ten years ago. The malaise in the international monetary system is not just over the dollar but over the outlook for currencies generally.

The upshot is that over the past three weeks the mark has been in heavy speculative demand, against dollars as well as against other European currencies. The demand has been particularly strong ahead of weekends, when realignments of European currencies generally occur. Intervention within the EMS has swelled to $2.8 billion equivalent. now increasingly in marks rather than dollars, which has helped relieve pressure on the dollar. Intervention in dollars by the German and U. S. authorities amounted to million was by the United States. The immediate pressures in the EMS, mainly against the Danish, Belgian and French currencies, are likely to continue until one of these weekends a realignment is agreed upon or a successful bear squeeze is pulled off as a result of the very high interest rates now prevailing in those countries. Meanwhile, the Bundesbank has continued to use swaps against U. S. Treasury hills held in its own portfolio to mop up mark liquidity as fast as it is created.

ofwhich $1,580

Our intervention, while sizable. has been of a defensive nature. In the market we have shown ourselves as highly reluctant to give ground. particularly as the mark rate approaches the DM 1.80 level, which traders consider an important psychological benchmark. The U. S. authorities, ofcourse, are not wedded to that rate. But in the current highly unstable exchange market environment, the more the Desk backs away, the bigger the outpouring of offers of dollars from speculators. corporate treasurers, and portfolio investors. Consequently, to keep some sense of two-way risk in the market, we have varied our tactics~ The Treasury still has some $2.1 billion of its mark availabilities and has the possibility of acquiring more marks--as through the issuance of additional Carter notes-should the need arise. Overall, our swap drawings on the Bundesbank rose a net of $609 million and now total $2.7 billion. This leaves the System with $3.3 billion [available] under the swap lines.

Meanwhile, I think that an increasing number of people in the market accept the more favorable medium-run scenario I laid out last month. Our trade and current accounts are adjusting and a further dramatic adjustment is expected if not over the next months at least over the next year. The Federal Reserve’s tightening moves have been taken as a signal of the System’s determination to fight inflation despite the action ofthe Bundesbank. And once the oil price increase works its way further through our price indexes, the U. S. inflation rate should begin to abate. But traders are still reluctant to bet on this scenario as long as more immediate uncertainties dominate market psychology.

F O X MEETING SEPTEMBER 18, 1979

REPORT ON OL’EN MARKET OPERATIONS

M r . S t e r n l i g h t made t h e fo l lowing s ta tement :

I n response t o d e c i s i o n s a t t h e l a s t Committee meeting,

and s t r o n g aggrega te s i n t h e intervening p e r i o d , t h e Account

Management aimed f o r a f i rming of money m a r k e t c o n d i t i o n s t h a t

c o n t r i b u t e d t o higher i n t e r e s t rates across a broad f r o n t . Immediately

fo l lowing t h e August 14 meeting, t h e Desk began seek ing a Federal

funds rate around 11 p e r c e n t , t h e midpoint of t h e new 1 0 3/4 - 11 1/4 p e r c e n t range, and up from the previous o b j e c t i v e of 1 0 5/8 pe rcen t

or s l i g h t l y h igher . By August 2 3 , t h e Board s t a f f estimates of

t h e a g g r e g a t e s appeared s u f f i c i e n t l y strong--well above t h e range

for M and v i r t u a l l y a t t h e t o p f o r M2 - - tha t t h e Desk’s o b j e c t i v e 1 w a s r a i s e d t o 11 1/4 p e r c e n t . A week later, t h e aggrega te s appeared

even a b i t stronger and t h e Committee voted t o p rov ide an a d d i t i o n a l

1/4 p e r c e n t leeway t o raise t h e funds rate, though w i t h t he under-

s t and ing t h a t not a l l t h e leeway would be used immediately. Fu r the r

ad jus tments were t o be made i n response t o subsequent in format ion

on t h e aggrega te s and performance of t h e dol lar i n t h e f o r e i g n

exchange market. I n response , s t a r t i n g a t t h e end o f August t h e

Desk aimed for a funds rate of abou t 11 3/8 percen t , and t h a t

o b j e c t i v e h a s cont inued up to now.

I n implementing t h e moves t o 11 1/4 and 11 3/8 percen t

t h e Desk moved i n a g i n g e r l y f a s h i o n , t a k i n g c a r e t o avoid g i v i n g

t h e marke t t h e impression t h a t the objective might be even h i g h e r

t h a n it w a s . P a r t l y because of t h i s , and a l s o due t o some un-

expected reserve bulges , t h e funds r a t e averaged somewhat under

t h e D e s k ' s o b j e c t i v e s i n l a t e August and e a r l y September. Mcver-

t h e l e s s , market p a r t i c i p a n t s came away w i t h a p r e t t y good idea

o f what w e were s h o o t i n g f o r , perhaps w i t h a l a g of a day o r two

a t t imes. I n t h e c u r r e n t week, funds are averaging ve ry c l o s e t o

t h e 11 3/8 p e r c e n t o b j e c t i v e .

O u t r i g h t o p e r a t i o n s were v i r t u a l l y a l l i n b i l l s during

t h e p e r i o d , though t h e r e were coupon purchases of n e a r l y $1 b i l l i o n

j u s t b e f o r e t h e l a s t meeting. N e t purchases o f b i l l s from fo re ign

accounts came to abou t $ 2 b i l l i o n , p a r t l y o f f s e t by a redemption

of $ 2 0 0 m i l l i o n i n b i l l s and a s m a l l redemption of agency i s sues .

Repurchase agreements w e r e used a c t i v e l y t o provide r e s e r v e s i n t h e

f i r s t h a l f of t h e p e r i o d , w h i l e matched-sale purchase t r a n s a c t i o n s

were employed t o mop up r e s e r v e s o n several days toward t h e l a t t e r

p a r t of t h e i n t e r v a l , i n a d d i t i o n t o t h e execut ion of matched t r a n s -

a c t i o n s w i t h foreign accounts each day.

La rge ly i n r e a c t i o n t o t h e h i g h e r funds r a t e , and a n t i c i -

p a t i o n of f u r t h e r f i r m i n g t o come, i n t e r e s t rates r o s e over a broad

spectrum d u r i n g t h e p a s t f i v e weeks. While t h e System's funds

o b j e c t i v e rose a b o u t 7 0 b a s i s p o i n t s , s o m e o t h e r s h o r t rates pushed

up by a f u l l pe rcen tage p o i n t o r more, spu r red by en larged c r e d i t

demands and h i g h e r f inanc ing c o s t s . Among the sha rpes t g a i n s were

t h o s e on bank CD'S and commercial paper--about 1 3/8 percentage

p o i n t s . The banks' prime rate climbed 1 1/4 percen t t o a new high

of 13 p e r c e n t . Treasury b i l l s w e r e auc t ioned yes te rday a t abou t

10.35 and 10.32 p e r c e n t for t h e 3- and 6-month i s s u e s , compared

w i t h 9.50 and 9.48 percent j u s t before t h e l a s t meeting.. Yes te rday ' s

6-month rate w a s a new reco rd w h i l e t h e 3-month was down somewhat

from t h e record of 1 0 . 5 3 p e r c e n t a wcck e a r l i e r .

Shor t m a t u r i t y Treasury coupon i s sues - -ou t to about 20

months matur i ty- -a l so r o s e by a f u l l percentage p o i n t o r more i n

y i e l d , w h i l e i n t e rmed ia t e i s s u e s i n t h e 2 - 5 a r e a were up about

50 - 8 5 b a s i s p o i n t s . For t h e longes t m a t u r i t i e s , y i e l d inc reases

t ape red o f f t o a b o u t 20 - 25 b a s i s points--which i s s t i l l q u i t e

s u b s t a n t i a l . Long t e r m c o r p o r a t e s and tax-exempts were a l s o up

by roughly t h a t amount.

I t w i l l be r e c a l l e d t h a t on some o t h e r r e c e n t occasions,

t h e longer market r e a c t e d t o evidence o f a f i r m e r System po l i cy by

hold ing s t eady o r even d e c l i n i n g i n y i e l d a s market p a r t i c i p a n t s

took h e a r t t h a t s t u r d i e r a c t i o n was being taken to d e a l w i t h

i n f l a t i o n . The d i f f e r e n t r e a c t i o n t h i s t i m e may have come because

of f e e l i n g s t h a t i n f l a t i o n is so deeply imbedded t h a t i t w i l l t ake

c o n s i d e r a b l e t i m e to r o o t o u t , perhaps l eav ing t h a t e l u s i v e peak

i n rates s t i l l some d i s t a n c e away. The r e c e n t rise, wh i l e s e t t i n g

new peaks f o r t h i s year f o r s h o r t rates, and al l - t ime peaks f o r

Treasury b i l l s , d i d n o t r each t h e h ighs of l a s t s p r i n g for longer

i n t e r m e d i a t e and long-term rates. I n d i c a t i v e o f m a r k e t psychology,

d e a l e r p o s i t i o n s i n Governments matur ing i n ove r a yea r have pushed

t o a near-record s h o r t . The d e a l e r s ' n e t s h o r t p o s i t i o n i n over

1-year issues w a s abou t $500 m i l l i o n a t t h e t i m e of t h e las t meeting,

and most r e c e n t l y h a s been around $1.4 b i l l i o n .

The m a j o r i t y e x p e c t a t i o n i n t h e market as of t h i s p o i n t ,

i n my view, is t h a t t h e r e is still some f u r t h e r f i rming t o come,

t o tame t h e aggrega te s and c o n t a i n i n f l a t i o n .

q u i t e so predominant now as a f e w days ago, as some p a r t i c i p a n t s

The view is n o t

think that a more pronounced business softening is on the way and

that this will preclude more rigorous restraint. But the more

prevalent view is that some further restraining steps are likely.

Certainly few, if any, observers have expressed optimism about

the near-term prospects for curbing inflation.

Finally, I should call the Committee's attention to the

possibility of some disruption to the financial markets as the

Congress copes again with the debt ceiling. Congressional action

must be taken before September 30, or the limit reverts to $400

billion. A Congressional recess is scheduled to begin September 28

so that is perhaps the more critical date--and indeed some problems

would arise if there is no action by September 25 as that may be

the date the Treasury would have to start postponing auctions of

securities. Depending on the course of events, we may have to

consider actions to help deal with special circumstances that emerge

from a debt limit bind.

James L. Kichl ine September 18, 1979

FOMC Brief in&

1 Economic a c t i v i t y on average now appears l i k e l y t o inc rease a b i t

i n t h e c u r r e n t q u a r t e r from the l e v e l t h a t p reva i led i n t h e second qua r t e r .

The s t a f f ' s assessment of new information s i n c e the l a s t meeting of the

Committee has l e d us t o r e v i s e upward expected f i n a l s a l e s and inventory

investment during the summer months. A t the same time, however, a d d i t i o n a l

evidence i s a v a i l a b l e of a probable reduct ion i n a c t i v i t y i n t h e months

ahead.

GNP s t r e t c h i n g i n t o t h e f i r s t h a l f of 1980 has n o t been a l t e r e d apprec iab ly

by r ecen t and prospec t ive developments.

Overa l l , the s t a f f ' s f o r e c a s t of a moderate c y c l i c a l dec l ine i n r e a l

, Much of the upward r e v i s i o n of f i n a l s a l e s i n the c u r r e n t q u a r t e r

i s a t t r i b u t a b l e t o h igher personal consumption expendi tures .

s a l e s i n August were repor ted t o have increased 3 / 4 percen t , which undoubtedly

amounted t o l i t t l e change i n r e a l terms.

w e r e rev ised upward. To some e x t e n t the r ecen t h a l t i n t h e series of d e c l i n e s

i n r e t a i l s a l e s experienced during the sp r ing i s a t t r i b u t a b l e t o the d i r e c t

and i n d i r e c t e f f e c t s of improved a v a i l a b i l i t y of gaso l ine . I n add i t ion ,

domestic au to s a l e s i n August and e a r l y September rose cons iderably i n response

t o r eba te s and dea le r i ncen t ives f o r overstocked '79 model cars. While d e a l e r s

have pared a u t o inven to r i e s s u b s t a n t i a l l y , p a s t experience sugges ts t h a t a

l a r g e proport ion of such sales came a t t h e expense of f u t u r e s a l e s r a t h e r

t han adding permanently t o customer a u t o demands; thus our f o r e c a s t con ta ins

a drop of around 8 percent i n domestic a u t o s a l e s i n the f o u r t h qua r t e r .

T o t a l r e t a i l

But s a l e s f o r bo th June and J u l y

The clean-up of excess a u t o inven to r i e s s o f a r has r equ i r ed cons ider -

a b l e adjustments i n product ion a long wi th increased s a l e s . I n August motor

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veh ic l e s and p a r t s accounted f o r two-thirds of t h e 1.1 percen t drop i n

i n d u s t r i a l production. Outside the motor vehicle s e c t o r , product ion dec l ines

gene ra l ly were small a l though widespread among consumer and bus iness products

a s w e l l as ma te r i a l s .

Fur ther downward adjustments i n product ion w i l l be necessary i n

order t o achieve and main ta in a des i r ed level of i nven to r i e s un le s s consumer

and bus iness s a l e s were t o pick up. Such a sus ta ined r i s e of s a l e s f o r

consumer and investment goods does not seem probable. A t t h e consumer l e v e l

r e a l d i sposable income has been on a downward path, sav ings r a t e s a r e h i s t o r i -

c a l l y low, debt burdens a r e high and consumer a t t i t u d i n a l surveys p o i n t t o

concerns about c u r r e n t and f u t u r e economic condi t ions . Attempts t o main ta in

r e a l s tandards of l i v i n g should tend t o provide some suppor t t o consumption,

bdt a r e u n l i k e l y t o outweigh fundamental nega t ive f o r c e s a t work.

I n the investment s e c t o r housing starts i n J u l y w e r e s t i l l f a i r l y

s t rong a t 1.8 m i l l i o n u n i t s annual r a t e and home s a l e s advanced. Since then,

however, a l r eady h igh mortgage i n t e r e s t r a t e s have r i s e n f u r t h e r and nonprice

terms have t ightened.

dec l in ing housing market a c t i v i t y t h i s yea r and i n t o e a r l y 1980.

and equipment spending, da ta f o r J u l y sugges t some rise i n cons t ruc t ion Out-

l ays and shipments of nondefense c a p i t a l goods.

investment ac t iv i ty - - inc lud ing new o rde r s , the r e c e n t Comerce survey of

spending i n t e n t i o n s , and c o n t r a c t awards--al l p o i n t t o a dece le ra t ion .

The f i n a n c i a l evidence and damped demand f o r c e s sugges t

For p l a n t

However, i n d i c a t o r s of f u t u r e

The s t a f f ' s f o r e c a s t has b u i l t i n t o i t a g e n e r a l weakening of con-

sumer and bus iness demands a s w e l l as a s i z a b l e drop i n inventory investment

from the pace of the second and t h i r d q u a r t e r s .

on a book value b a s i s was huge, even a f t e r a l lowing f o r r a p i d p r i c e increases .

I n J u l y the rise i n i n v e n t o r i e s

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Nearly one-fourth of the accumulation was i n motor vehicles and p a r t s where

a c t u a l dis investment occurred i n August and so f a r t h i s month.

chunk was i n foods, presumably r e f l e c t i n g good crops, some s t r i k e e f f e c t s , and

temporary lags i n exporting.

rap id ly- -espec ia l ly consumer goods a t gene ra l merchandise stores--and the

inventory s i t u a t i o n i s a cause of concern.

Another l a r g e

But even so o t h e r inventor ies were r i s i n g

Forecas t ing the s i z e and timing of an inventory adjustment is a

hazardous a f f a i r . Our f o r e c a s t of a smooth and f a i r l y rap id balancing of

des i r ed and a c t u a l inventor ies relies heav i ly on the r a t h e r cau t ious behavior

of bus inesses throughout the c u r r e n t c y c l i c a l expansion, and t h a t cau t ion is

re in fo rced of course by the c u r r e n t l y p reva i l i ng level of i n t e re s t r a t e s .

A f u r t h e r sof ten ing of labor markets would be c o n s i s t e n t w i th the

s t s f f ' s f o r e c a s t of economic a c t i v i t y .

was unchanged, whi le the average length of t h e workweek dec l ined , manufactur-

ing employment was reduced f o r the f i f t h consecut ive month, and the unemploy-

ment r a t e rose 0.3 percentage point . I n l i g h t of c u r r e n t circumstances,

increases i n the unemployment r a t e averaging 0.3 percentage p o i n t pe r month

over the balance of the year would not be su rp r i s ing .

I n August t o t a l nonfarm employment

On the p r i c e s i d e we have not a l t e r e d the f o r e c a s t s i g n i f i c a n t l y .

The g ross business product f i x e d weight d e f l a t o r is expected t o be r i s i n g

a t around 8-1/2 percent annual r a t e l a t e n e x t year compared t o t h e recent 10

percent rate. The s luggish economy i n prospec t , along wi th a slowing i n the

rap id increase of energy p r i c e s , i s expected t o c o n t r i b u t e important ly t o

reduced, although s t i l l high, r a t e s of i n f l a t i o n . W e have no t assumed much

success by the Adminis t ra t ion i n hold ing down wages and p r i c e s during t h e

second year of i t s r e s t r a i n t program beginning October 1. The d e t a i l s of

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the revised guidel ines w i l l not be avai lable u n t i l l a t e r t h i s month, although

i t appears that the program w i l l tend t o be relaxed, a t l e a s t on the wage

s i d e .

FOMC B r i e f i n g S . H . Axi l rod S e p t . 18, 1979

Fol lowing 5 months o f weak growth b e g i n n i n g i n November 1978,

b o t h PI-1 and 1.1-2 have been expanding v e r y r a p i d l y o v e r t h e 5% month p e r i o d

from March a s a b a s e through t h e f i r s t two weeks o f September--with M-1

expanding a t a b o u t an 11 p e r c e n t annua l r a t e and M-2 a t a 1 2 % p e r c e n t r a t e .

I would i n t e r p r e t t h i s a c c e l e r a t e d growth f o r t h e most p a r t a s a r e t u r n

t o t h e r e l a t i o n s h i p s between money, nominal GNP, and i n t e r e s t r a t e s t h a t

might be e x p e c t e d on t h e b a s i s of p a s t h i s t o r y . There is some ev idence for

t h i s s i n c e t h e a c c e l e r a t i o n r e f l e c t s ma in ly resumed growth o f demand

d e p o s i t s and s a v i n g s d e p o s i t s - - a c c o u n t s from which b u s i n e s s e s and consumers

began s h i f t i n g funds l a s t November when t h e y s t a r t e d r e - e v a l u a t i n g money

p o s i t i o n s f o l l o w i n g t h e i n t r o d u c t i o n o f ATS a c c o u n t s and the s imul t aneous

a b r u p t and seeming ly more permanent r i s e i n marke t i n t e r e s t r a t e s a s s o c i a t e d

w i t h t h e d o l l a r s u p p o r t program. This s t o c k a d j u s t m e n t i n r e t r o s p e c t a p p e a r s

t o have ended i n t h e s p r i n g .

Most r e c e n t l y , money appea r s t o be growing a b i t more r a p i d l y

t h a n h i s t o r i c a l r e l a t i o n s h i p s would s u g g e s t . There would appea r t o be a t

l e a s t t h r e e p l a u s i b l e e x p l a n a t i o n s , w i t h d i f f e r i n g i m p l i c a t i o n s f o r spend ing

O K i n t e r e s t r a t e s . F i r s t , i t might b e assumed t h a t e a r l i e r t h i s y e a r the

p u b l i c drew down c a s h b a l a n c e s more t h a n t h e y found d e s i r a b l e , and r e c e n t l y

t h e y have been r e - a d j u s t i n g t o some e x t e n t . This a s sumpt ion would n o t h a v e

any p a r t i c u l a r i m p l i c a t i o n s f o r spend ing o r i n t e r e s t r a t e s i n the f u t u r e ,

s i n c e t h e p u b l i c would s imply wish t o h o l d t h e c a s h .

A second p o s s i b i l i t y would be t h a t t h e p u b l i c i s now add ing t o c a s h ,

a s w e l l a s t o o t h e r l i q u i d a s s e t s , f o r p r e c a u t i o n a r y r e a s o n s i n view Of the

u n c e r t a i n economic ou t look . Such b e h a v i o r i s t y p i c a l l y n o t l o n g l a s t i n g , and

t h u s t h i s added c a s h i s l i k e l y t o be s p e n t O K i n v e s t e d i n o t h e r f i n a n c i a l

a s s e t s . O K , t h i r d , i t may a l s o be t h a t M - 1 i s r i s i n g because the Federal

Reserve i s at tempting t o mute upward i n t e r e s t r a t e p re s su res i n a per iod

o f r e l a t i v e l y s t rong , perhaps s t rengthened short- term c r e d i t demands.

Cash so suppl ied would a l s o be q u i t e l i k e l y t o be spent O K i nves t ed f a i r l y

soon, r a t h e r than be he ld fo r a longish per iod.

O u r p ro j ec t ions of a slowing i n money growth over t h e months ahead

assume, e s s e n t i a l l y , t h a t p recaut ionary add i t ions t o cash w i l l aba t e and

t h a t Short-term c r e d i t demands w i l l s l a c k o f f l a t e r i n the year i n l i n e wi th

weakening bus iness a c t i v i t y . Our p ro j ec t ions do not assume t h a t r ecen t

a d d i t i o n s t o cash w i l l be spent i n s u f f i c i e n t volume t o s u s t a i n bus iness

a c t i v i t y and thereby genera te e i t h e r a renewed need fo r cash f o r t r a n s -

a c t i o n s purposes o r a sharp r i s e i n v e l o c i t y occasioned by spending out of

p re -ex i s t ing balances. Rather , they assume t h a t any s u r p l u s cash w i l l ,

mainly, be inves t ed , thereby p u t t i n g some downward pressure on i n t e r e s t

r a t e s and/ O K leading t o slower growth i n money over the nex t few months.

J i m has discussed the f a c t o r s lead ing t o the s t a f f p r o j e c t i o n of

a weakening G N P i n the four th qua r t e r . Such a weakening appears t o depend

t o a g rea t ex ten t on elements endogenous t o t h e nonf inanc ia l economy--such

a s dec l ines i n r e a l personal income and inventory imbalances. From a

f i n a n c i a l pe r spec t ive , we have not been a b l e t o d e t e c t the k inds of

condi t ions t h a t have i n p a s t cyc les been a s soc ia t ed with c l e a r c o n s t r a i n t s

on c r e d i t ava i l ab i l i t y - - such a s , widening y i e l d spreads between low and

high-grade market ins t ruments , o r a cons iderable worsening i n indexes

r ep resen t ing changing bank a t t i t u d e s toward lending. There i s s u r e l y some

r e s t r a i n t i n the housing market, but t h e wi l l i ngness oE S&L's t o make

mortgage commitments appears t o have he ld up a l i t t l e b e t t e r than i n

previous per iods of r e s t r a i n t .

- 3 -

F i n a n c i a l r e s t r a i n t under c u r r e n t c o n d i t i o n s wou ld , o f c o u r s e , need

t o come mos t ly from t h e impact of i n t e r e s t r a t e l e v e l s on t h e w i l l i n g n e s s t o

borrow. Tiere, t h e prime r a t e a t 13 p e r c e n t migh t be c o n s i d e r e d r e s t r i c t i v e , and

would encourage i n v e n t o r y l i q u i d a t i o n , g iven t h e r e l a t i v e l y weak s a l e s o u t l o o k

and e s p e c i a l l y i f any s i g n s deve lop o f s o f t n e s s i n p r i c e s of goods h e l d

i n i n v e n t o r i e s .

With r e g a r d t o t h e d e c i s i o n b e f o r e t h e Committees today , a f e w

c o n s i d e r a t i o n s may be r a i s e d , based i n p a r t on t h e p r e c e d i n g a n a l y s i s .

S t r a t e g y toward t h e F e d e r a l funds r a t e i n t h e weeks ahead i n v o l v e s b a l a n c i n g

e f f o r t s t o reduce growth i n t h e a g g r e g a t e s and c u r b i n f l a t i o n a g a i n s t an a p p a r e n t l y

weakening economy. One obvious approach a t t h i s t i m e would b e t o s t a n d

p a t i n terms o f t h e F e d e r a l funds r a t e , w h i l e a s s e s s i n g whether endogenous

f o r c e s i n t h e n o n f i n a n c i a l s e c t o r s o f t h e economy--as w e l l a s t h e l agged

e f f e c t s o f r e c e n t t i g h t e n i n g a c t i o n s - - w i l l i n f a c t weaken t h e economy enough

t o b r i n g money growth down t o more a c c e p t a b l e l e v e l s . On t h e o t h e r hand,

t h e Committee might c o n s i d e r some l i t t l e f u r t h e r t i g h t e n i n g of t h e funds

r a t e on t h e grounds t h a t more i n s u r a n c e i s needed-- in t h e form, f o r example,

of encouraging more r e s t r a i n t on c r e d i t a v a i l a b i l i t y - - i f the p r o c e s s of

moving toward s i g n i f i c a n t l y s lower money growth i s to b e more c e r t a i n .

F i n a l l y , i t migh t b e no ted t h a t weakness i n economic a c t i v i t y may

a rgue f o r a p o l i c y o f e a s i n g t h e funds r a t e . However, unde r e x i s t i n g C i r -

cumstances, such a n argument needs t o be weighed a g a i n s t t h e absence o f any

c l e a r and l a s t i n g s i g n o f a s lowing i n money g rowth , t h e absence of e v i d e n t

c o n s t r a i n t s on c r e d i t a v a i l a b i l i t y , and t h e d e s i r a b i l i t y o f a v o i d i n g

s i g n a l s t h a t marke t s might i n t e r p r e t a s a weakening i n t h e r e s o l v e t o

combat i n f l a t i o n .